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Property's shining star

Has the high-growth industrial property market reached a peak?
January 23, 2020

Motorway-flanking, grey steel warehouses and industrial units are hardly the most glamorous prospect in real estate, but the sector’s strong performance has sparked a frenzy among investors searching for returns in a low-yield world.

No longer the target of domestic funds alone, European industrial and logistics properties have piqued the interest of investors from the US and Far East. Most recently, US private equity group Blackstone launched a £500m bid for Aim-traded Hansteen (HSTN) in December, a developer and landlord with a £605m portfolio of urban multi-let industrial assets across the UK.

An undersupply of space and rising demand for so-called ‘last mile’ delivery facilities has pushed up rents and attracted a rush of investment into the sector, pushing up property valuations. 

That trend has not gone unnoticed by investors in public markets, with shares in most of the sector’s constituents trading at a premium to net asset value (NAV). That is a contrast to the sizeable discounts being applied to the market value of office and retail property groups, a point borne out last year when Segro (SGRO) leap-frogged office and retail landlord Land Securities (LAND) to become the UK’s largest listed property group. 

The rise of ecommerce has driven demand for warehouse space near major urban centres, which has been exacerbated by a lack of new development in the years immediately following the 2008 financial crisis. That under-supply has partly been driven by the increasing conversion of industrial space to residential use, while the speculative funding markets have become more discerning.

“Historically investors would have had 10-12 per cent of their portfolio in industrial as a way of topping up their income,” says Goodbody analyst Colm Lauder. “That has turned on its head; you’re buying industrials now for long leases and good covenants.” 

The average lease length across prime UK industrial property was 9.9 years at the end of June, according to research by MSCI and Savills, up from eight years in 2011. Meanwhile, vacancy rates had fallen to 6.7 per cent on average by the end of 2019, compared with 21.2 per cent in 2011, according to research by real estate services group Savills (SVS).  

That is in stark contrast to the retail industry, as struggling shopping centre and high-street tenants have become more reluctant to commit to longer leases. 

The relative security of the income stream provided by industrial tenancies is a major attraction for the purchasers of these assets, says Edward Cornwell, a partner in Cushman & Wakefield’s investment team. “They’re not looking for necessarily a phenomenal, double-digit internal rate of return,” says Mr Cornwell. 

Will Fulton, investment manager of Aberdeen Standard Investment's UK Commercial Property Reit, says he looks to big-box warehouses in the regions for a steady yield and urban logistics around London and the south-east for rental growth. 

The valuations attached to industrial property have also been pushed up by a lack of stock to invest in, which has led to greater competition within the European industrial markets. Ten to 15 years ago property developers built warehouses for sale to institutional investors, says Savills head of industrial research, Kevin Mofid. “What’s happened as the market’s matured is most of the developers now develop buildings and they hold them in their own portfolios,” says Mr Mofid. 

 

Peak prices hit?

Yields on prime UK industrial property had fallen to below pre-financial crisis levels by the end of last year at 4 per cent for multi-let property and 4.2 per cent for distribution assets, from 8.1 per cent and 7.5 per cent, respectively, in 2009. 

In London and the south-east, where the capacity squeeze has been most keenly felt, yields on prime industrial space around the Heathrow area came in at 4 per cent over the year to September, according to research by Cushman & Wakefield, in line with those attached to investment yields for offices in the City of London and only slightly above the 3.5 per cent of those in the West End. 

Yet the rate of value growth within the UK market has started to slow, with investment yields last year flat on 2018, due to expectations that the pace of future rental growth will moderate. Prime industrial rents grew by 2 per cent during the first three quarters of last year, according to data from Cushman & Wakefield, down on an annual increase of 7.9 per cent in 2017 and 3.2 per cent in 2018. 

“Where we have got to now is that we are a bit further on along in the cycle and [the sector is] a bit more mature,” says Mr Cornwell. While headline property values and rental rates are being maintained, it is likely that location will become increasingly important, he adds. Development appetite has become more concentrated on locations inside the M25, around Manchester and within the ‘Golden Triangle’, which encapsulates areas that are within easy reach of high populations.  

Will Fulton, investment manager of Aberdeen Standard Investment's UK Commercial Property Reit (UKCM) shares this sentiment: “I would say that rental growth has slowed. It’s very important to be in the right locations.” That includes areas where there is good access to labour, as well as proximity to major motorways. Mr Fulton says he looks to regional big-box warehouses for stable yield and urban logistics – which account for 55 per cent of the Reit's industrial allocation – for rental growth. 

The lofty prices demanded for industrial property in the south-east and urban logistics sites has deterred some investors from increasing their exposure to the sector. Those are both areas of the market that BMO Commercial Property Trust (BCPT), which has 17 per cent of its £1.4bn portfolio invested in industrials, is underweight in, says investment manager Richard Kirby. 

“That’s something that we would really like to start to address, but pricing over the past couple of years has been extremely aggressive,” says Mr Kirby. “It’s very hard for us to compete in that sector,” he says, pointing to the 3 per cent investment yields attached to some assets sold within Greater London over the past year. 

Given the rising rents being earned by industrial landlords, and the relative security of those income streams, it is unsurprising that most of the sector’s UK Reits now trade at sizeable premiums to NAV. Yet if rental growth is slowing, are the price tags attached to those shares justified? 

“The premiums I would consider still to be warranted, whether the scale of the premiums is warranted is questionable,” says Mr Lauder. 

Yet while growth in the value of these assets may slow, industrial property investment yields still look attractive when compared with those on offer from European government bonds, says Mike Barnes, an associate in Savills European research team, particularly since the European Central Bank has indicated that interest rates are likely to be cut rather than raised in the near term. “That’s going to keep further pressure on yields across some of the key European markets as well,” he says.  

Asset values on the continent have also not risen to quite the same heights as the UK since online retail has been slower to take hold. That could indicate that the logistics and industrial property markets have higher growth prospects, boding well for companies such as Segro, which has 70 per cent of its lettable space located in continental Europe. 

The compression of investment yields should also be viewed in relation to industrial development costs, argues Andrew Bird, managing director of Warehouse Reit (WHR) investment manager Tiltstone Partners, particularly in the case of urban warehouses. “Investment values for urban warehouses [are] still less than the cost of replacement,” says Mr Bird. That should continue to stymy capacity and drive up rents, he says. 

Structural changes within the retail industry show no sign of abating and there is still a lack of capacity, within the urban logistics market in particular. That makes the earnings streams of industrial landlords look increasingly secure compared with those generated by floundering high street and shopping centre stores and even offices. During the first half of last year, 11 per cent of passing rent generated by the UK's offices was greater than the open market value, according to research by MSCI and BNP Paribas, higher than the retail and industrial sectors and putting the market at risk of over-renting. 

However, with prime industrial rents forecast to grow at an annual rate of 2 per cent over the next five years, according to Cushman & Wakefield, investors in UK industrial property should cast a more critical eye over the premiums they are being asked to pay. 

 

Three ways to play logistics

Warehouse Reit

After raising an initial £150m by listing shares on Aim in 2017, Warehouse Reit has been focusing on warehouse storage and distribution assets close to urban areas. Capitalising on the shortage of these types of assets, which account for 79 per cent of its portfolio, has generated a solidly rising income stream for the group. During the final three months of 2019 the group secured 24 new lettings at 7.5 per cent ahead of estimated rental values (ERV) at the end of September and 20 lease renewals at 6.4 per cent ahead of ERVs at that same date. 

The ability to continue raising rents translates into a growing dividend for shareholders. In November management raised the target dividend for the financial year ending March 2020 above the 6p a share paid in 2019, with analysts at house broker Peel Hunt forecasting 6.2p. At the current price, that leaves the shares offering a generous potential dividend yield of 5.3 per cent, rising to 5.6 per cent the following year, based on the same broker’s forecasts. After gaining almost a fifth in value over the past 12 months, the shares trade at a 6 per cent premium to forecast NAV at March 2020, but that looks like a price worth paying for the secure income on offer.

 

LondonMetric Property

LondonMetric Property’s (LMP) 2019 acquisition of rival A&J Mucklow ramped up the FTSE 250 group’s expansion into the urban logistics industry and made it the third-largest industrial property specialist listed on London’s equity markets. Retail parks made up just 3.7 per cent of the group’s portfolio at the end of September, after management made the decision in 2015 to dramatically reduce its exposure to the struggling sector. That has left distribution assets accounting for 71.2 per cent of assets, including 34.5 per cent in urban logistics. 

Like its peers, the group has demonstrated its ability to renew leases at review that are comfortably passing rents, with the six distribution assets up for renewal during the first half of last year secured at 13 per cent above passing on a five-yearly equivalent basis. The distribution portfolio also benefits from long lease lengths, with the average weighted average unexpired lease terms (WAULT) standing at 10 years. Over the past three years the group has returned 36 per cent for shareholders, including dividends, outperforming the 21 per cent generated by the IPD All Property index over the same period. The shares trade at a 28 per cent premium to forecast March 2020 NAV, based on Panmure Gordon estimates, which reflects the greater scale of the distribution portfolio compared with peers. 

 

Urban Logistics 

As the name suggests, Aim-traded Urban Logistics (SHED) is solely focused on small and medium-sized multi-let ‘last mile’ delivery assets, typically in the 50,000-100,000 sq ft range. Since coming to market in 2016, Urban Logistics has generated annual returns of 16.1 per cent, including dividends, for shareholders. Given the lack of supply of these types of assets, it is perhaps unsurprising that the company’s portfolio was fully occupied at the end of September, with a WAULT of 6.1 years. 

Like-for-like rental income rose more than a third during the first half of the current financial year thanks to rent reviews and new lettings being agreed comfortably ahead of passing rates. For income seekers, the rationale for buying into Urban Logistics is clear – a 7p-a-share dividend was paid in respect of 2019 and analysts at Hardman & Co forecast a payment of 7.8p for 2020, which would leave the shares offering a potential yield of 5.5 per cent. However, the market has started to catch on to the Reit’s appeal, with the discount gap between the share price and the portfolio’s NAV at the end of September now closed. That may also be why an equity raise is being considered to potentially purchase a pipeline of identified assets worth in excess of £300m.

 

NamePriceEPS (p)EPS 1 yr chg (%)Return on equity (%)Dividend per share AdjDividend yield (%)Dividend cover (by EPS)Price to NAVfc Dividend per share Adj
BMO Commercial Property Trust Ltd113.5p11.6-62.934.5410.8-
Custodian Reit PLC115.3p6.95.86.86.55.71.11.16.7
Londonmetric Property PLC235p8.52.45.28.23.51.11.38.6
LXI REIT PLC134.5p5203.75.44.11.11.2-
Schroder Real Estate Investment Trust Ltd55.65p2.77.44.32.64.61.10.8-
Segro PLC895.1p19.8-8.1318.82.111.420.4
Standard Life Investments Property Inc Trust Ltd96.1p5-164.84.850.91-
Tritax Big Box REIT PLC141.65p6.37.94.36.74.710.96.9
UK Commercial Property Trust Ltd87.2p3.4-11.83.33.74.20.80.9-
Urban Logistics REIT PLC144.5p4.942.95.874.911.17.6
Warehouse REIT PLC115p22205.865.31.116.2
Source: SharePad